India's central bank held its main interest rates steady, defying expectations for a rate hike, but stressed it was not soft on inflation and was poised to act if inflation does not fall in coming months.
The Reserve Bank of India (RBI), which raised rates at its two previous meetings to curb inflation and dampen the fall in its rupee currency, acknowledged it's decision was a close one and "there are obvious risks to waiting for more data, including the possibility that tapering of quantitative easing by the US Fed may disrupt external markets and that the Reserve Bank may be perceived to be soft on inflation."
"There is, however, reason to wait before determining the course of monetary policy," the RBI said, due to the risk to the weak economy from tightening policy too much given the long lag of any rate rise.
India's inflation rate, as measured by benchmark wholesale prices, rose for the sixth month in a row in November 7.52 percent from 7.0 percent in October, boosted by a 19.9 percent jump in food prices, fueling expectations that the RBI under its new governor Raghuram Rajan would again raise rates.
But the RBI expects headline inflation to fall significantly in the next months as vegetable prices are seen turning down sharply, the stable exchange rate would have a disinflationary impact along with the impact of the negative output gap, slower growth in services and the lagged effects of tighter monetary policy since July.
Indian financial markets were hit by financial outflows in May following a warning by the Federal Reserve's that it was considering reducing its asset purchases, with the rupee dropping 20 percent to a year-low of around 68 rupees to the U.S. dollar by end August from the start of the year.
But the rupee then rebounded and has been largely stable since early October, trading at 61 to the dollar today, partly due to financial market's trust in the stewardship of Rajan, a former official of the International Monetary Fund, and the RBI's moves to tighten policy.
The RBI took a series of exceptional measures in July to tighten its stance and defend the rupee, including raising the marginal standing facility (MSF) rate by 200 basis points. Then in September and October it raised the policy rate by a total of 50 basis points to at its scheduled policy review meetings and started to unwind the exceptional measures.
At its previous meeting in October the MSF rate was cut by a further 25 basis points to 8.75 percent to ensure liquidity in financial markets while the policy rate was raised by 25 points to 7.75 percent, reversing rate cuts earlier this year and leaving the rate 25 points below its level at the start of the year.
In the future, the RBI said it would not wait for its scheduled meetings to act.
"If inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted, so that inflation expectations stabiles and an environment conducive to sustainable growth takes hold," the RBI said.
The RBI is keenly aware that financial market volatility could pick up again "following the inevitable taper of quantitative easing in the US, given the large dependence of EMEs (emerging market economies) on external financing," it said.
India's economy improved modestly in the third calendar quarter, with Gross Domestic Product up by an annual 4.8 percent from 4.4 percent in the second quarter.
But industrial activity remains weak, growth in services and domestic consumption is lackluster and tighter government spending will add to the economic headwinds, making it critical for stalled investment projects to be revived.